Fully-Diluted Capitalization & Why It’s Important

Fully-Diluted Capitalization & Why It’s Important

You’ll hear a lot of jargon as a biotech startup founder raising money. In the world of venture capital and equity financing, one of those terms is “fully diluted capitalization.” The term comes into play when founders and investors negotiate a funding round and the startup’s valuation.

It’s an important term to know because it has a direct impact on how much of your company you’ll exchange in return for an investment. After all, you are trading ownership and control of the company for the money you need to keep building the business.

A basic overview of business capitalization will help. Founders usually begin with full ownership and full control over the company they start. Those founders usually use personal savings or friends-and-family support to begin the business. A founder in this stage may own all of the outstanding shares of the company, but some shares may be authorized but not issued. By keeping some shares authorized but not issued, the founder is planning for the future rounds of funding by investors.

It is also important to consider founders that are working with grant money. Grant money is startup money from government agencies, universities, or other programs that do not seek shareholder positions. Grant money can be part of the business’ funding but usually does not alter the list of shareholders or the leadership of the company.  

In other words, fully-diluted capitalization, or more specifically, what’s included in fully-diluted capitalization, along with your pre-money valuation, will change the percentage of ownership an investor will buy with a given dollar amount. That’s because your pre-money valuation is agreed on a “fully-diluted basis.” Or, that the price per share (PPS) is determined by considering any and all existing shares, as well as any and all shares authorized to be issued in the future.

For these reasons (economic impact and ownership dilution), knowing what fully-diluted capitalization means and what it typically includes is essential to your fundraising. When founders and investors aren’t on the same page regarding fully-diluted capitalization, deal negotiations can slow down, or even stop. Founders that cannot follow an investor’s questions about fully-diluted capitalization may become frustrated or embarrassed.

To help you avoid potential hang-ups during negotiations, this article will review what fully-diluted capitalization is and how it’s calculated.

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What is Fully-Diluted Capitalization?

There are several items that can be included or excluded from a company’s fully-diluted capitalization. Because it changes from case to case, there isn’t necessarily a perfect definition of the term.

It’s easiest to think of fully-diluted capitalization as any and all shares that have been issued by a company prior to a funding round. What else is included after that depends on the agreement between you and your investors.

The additional items that are included in the fully-diluted capitalization impact the amount of ownership the investor will receive for their investment and the percentage of ownership you will keep.

Because ownership can be affected by what your company’s fully-diluted capitalization includes, all parties involved in the financing should understand and carefully consider what items are included or excluded while negotiating term sheets.

A company’s fully-diluted capitalization generally includes the following:

  • Outstanding common stock (“outstanding” means the shares have been authorized, issued, and purchased)
  • Outstanding preferred stock (calculated on a converted basis; preferred stock is treated as if it has converted to common stock)
  • Outstanding stock options (as well as warrants, which are similar to options)
  • Reserved shares for the employee stock option plan (these shares aren’t issued yet, but it’s typical to see them included)
  • Any increase in the shares reserved for the employee stock option plan
  • And, in the case of startups, convertible securities such as convertible notes or SAFEs (these securities convert into shares when a specific funding round closes, assuming none of the escape clauses are triggered. It’s important to know the benefits and drawbacks of SAFEs.)

Outstanding common stock and preferred stock that can convert to common stock are the common items included (i.e., the total number of shares issued). Outstanding stock options, reserved shares, etc. are stocks that have been issued, but perhaps not exercised, and are not always included. However, most investors do include them.

In order to calculate the actual total ownership an investor will have, these options, warrants, and convertible securities are included in the fully-diluted capitalization. It is simply a way of looking to the future to see where that investor will stand when the other equity events have all taken place. By including these future events, the investor gets a full picture of price per share and dilution taking place in the future.

As you can see, what’s included in your startup’s fully-diluted capitalization will impact how much ownership an investor will receive for their investment.

Keep in mind that grants, SBA loans, and the founder’s personal wealth can affect the business’ working capital without changing the shares outstanding.

How is Fully-Diluted Capitalization Calculated?

To better understand what fully-diluted capitalization is, let’s review some basic examples of how it can be calculated. Let’s do this by adding in some items that you’ll generally be asked to include in your fully-diluted capitalization and using some examples to illustrate.

We start with the assumption that all preferred stock has converted to common stock. During your seed round negotiations, BioVC asks that you also include all outstanding stock options and warrants in your fully-diluted capitalization. It’s typical to see this request because even if the options owner doesn’t use them, the company can grant a similar number of options to someone who would take their place, e.g., a new hire.

If BioVC want to invest $2MM in your business at a $10MM pre-money valuation (sometimes called “two-on-ten” in VC jargon), and your fully-diluted capitalization is as follows:

Then, the price per share that BioVC would pay for its stock equals the pre-money valuation divided by the fully-diluted capitalization prior to the investment:

[pre-money valuation] / [fully-diluted capitalization prior to the investment] = PPS

In this case:

$10MM / 9,000,000 shares = $1.11 PPS

(Note: Some VCs will use an excel sheet to work with fully-diluted capitalization models and, if they allow so-called “sub penny” calculations, would use a PPS of 1.111 or even 1.1111, which will change the total shares the $2MM investment will acquire.)

When you add all of your company’s outstanding options and warrants, BioVC will pay $1.11 per share, which means they will be able to buy 1,801,801.8 shares with their $2MM investment, or 20.02% of the company.

Now, say that BioVC also asks that you include the shares you’ve reserved for your employee stock option plan. Investors would ask to have the reserved shares included in your fully-diluted capitalization because it gives them a better idea of how they’re ownership will be impacted when those options are exercised.

Let’s keep the numbers the same here but add in the reserved shares.

BioVC wants to invest $2MM at a $10MM pre-money. Your fully-diluted capitalization, with shares reserved for employee stock option plan, will look like this:

As you can guess, the price per share will change.

$10MM / 12,000,000 shares = $0.83 PPS

In this case, when the reserved shares for the stock plan are included, BioVC will pay $0.83 per share, meaning their investment of $2MM will buy them 2,409,638 shares, or 20.08% of the company.

Even though the increase in this example is small, it illustrates how fully-diluted capitalization can impact ownership. By including the items above, as well as any other items, such as shares set aside for future increase in the stock plan and convertible securities (convertible notes, SAFEs, etc.), the total amount of shares increases, and the PPS goes down.

Ultimately, it means that an investor’s $2MM investment in a startup with 8,000,000 outstanding shares based on a $10M pre-money valuation can buy a different number of shares, depending on what’s included in the company’s fully diluted capitalization.

In Conclusion

The fully-diluted capitalization of your startup, depending on what you and your investors agree upon, typically includes all issued shares, issued options and warrants, and options reserved in the employee stock option plan (ESOP).

Defining your capitalization on a fully-diluted basis establishes the price per share of your startup during that specific funding period. This determines how much of the company an investor or group of investors will be able to buy with their investment, and how much of the company you will retain as a founder or co-founder.

Knowing what fully-diluted capitalization means, when it’s used, and how it’s calculated helps you understand how much of the company you’re exchanging and why it works out the way it does.

This article is informative and is not meant to be fully comprehensive or represent legal advice. Before valuing your company or raising capital through equity financing, speak with professionals who have experience in startup and venture capital deals.